The blame game continues

If a product receives a glowing review by a research house and subsequently fails, should the research house be partly responsible? The Parliamentary Joint Committee recently grilled the industry on this matter, but as Milana Pokrajac finds, the legal precedent might have already been set. 

The financial services industry has many gatekeepers which ensure the end investor receives the right product and the right advice. 

However, the question often asked is whether investment research houses should be liable for any client losses when a product fails and if they should be more accountable for the quality of research they provide. 

The US Government was recently granted permission by a district judge in California to pursue its $5 billion civil lawsuit against Standard & Poor’s (S&P) for inflating credit ratings prior to the global financial crisis. 

The US Government had obtained evidence that S&P failed to downgrade ratings for collateralised debt obligations – despite knowing they were backed by deteriorating residential mortgage-backed securities. It accused the credit ratings agency of inflating ratings to win over the product issuers and bankers that pay for its services. 

Australia, too, recently saw a landmark ruling against the same ratings agency which could determine the way in which researchers are seen in the context of liability for client losses. 

The Australian Federal Court found S&P engaged in misleading and deceptive conduct when it gave a top AAA rating to CPDOs – a highly leveraged financial product marketed as Rembrandt notes, the value of which subsequently went into freefall. 

The court found that S&P based its rating solely on information provided by the creators of the product – ABN AMRO. 

Law firm Corrs Chambers Westgarth believes the future could see research providers liable for money lost by investors in financial products they rated, despite the absence of a contractual relationship. 

The recent case was a significant development, according to Corrs partner Rommel Harding-Farrenberg. 

“If a financial product has been inappropriately rated or marketed, the rating agency, originator and investment manager could be held accountable,” Harding-Farrenberg said. 

“On one hand, this is a good result for investors; on the other, it should spark major changes in the due diligence and analysis process undertaken by rating agencies and other involved parties.”  

PJC poses questions on accountability 

Two years ago, after the Treasury released its review of compensation arrangements for consumers of financial services, the then Financial Planning Association deputy-chief Deen Sanders advocated for a more “proportionate” compensation system for retail investors, which would see all industry participants – including research houses – appropriately liable. 

While this sparked initial questions about whether research providers should be liable, the debate did not go far. 

Since then, the Australian Securities and Investments Commission (ASIC) released its Regulatory Guide 79 – Research providers: Improving the quality of investment research – which provided direction on how to improve the production of research and appropriately manage the conflicts of interest apparent in researchers’ current business models. 

Failing to do so will result in further regulatory action and – if necessary – law reform, ASIC warned. 

However, the Parliamentary Joint Committee (PJC) on Financial Services and Corporations reignited this debate by posing questions to the regulator – and a few other industry participants – about the accountability of research houses and whether it should be increased. 

The regulator didn’t comment on whether researchers should be liable and said it had already clearly communicated the expectation that they needed to “lift their game”. 

As for advice groups, ASIC suggested they “vote with their feet”. 

“Where the service offering is not of good quality or where conflicts of interest are not effectively managed, we expect purchasers of research services to ‘vote with their feet’ and choose alternative providers who can deliver quality, reliable services,” ASIC told the PJC. 

Furthermore, the regulator said it expected advice providers to make inquiries and research the products they give advice on. 

“Where they use research, we expect them to conduct due diligence on research report providers that they intend to use, and our updated guidance in RG 79 will help them to do this.” 

Organisations which were also questioned by the PJC on this matter include investment research house Lonsec, Westpac-owned BT Financial Group, Macquarie Bank and non-aligned financial advice business Dixon Advisory. 

Lonsec argued the competitive nature of this sector in Australia would ensure only quality research reached financial advice groups. 

Research houses are typically engaged on short-term contracts and clients can quickly strip market share from those who are perceived to be managing their conflicts poorly or producing compromised or poor quality research, the company added. 

Furthermore, most researchers are asked about their ratings history with various failed financial products. 

“If a research house fails to meet any of the required standards or requirements, significant reputational damage would result,” Lonsec said.  

Is there an expectations gap? 

Lonsec identified a so-called ‘expectations overreach’ where some sections of the financial planning industry do not understand what a rating is and the degree to which it can be relied upon. 

In its statement to the PJC, Lonsec said some financial planning groups expected the role of investment research to accurately and consistently predict, and thus avoid, financial product failure. 

Furthermore, there was an expectation that well-rated financial products would consistently outperform their benchmarks – and that all well-rated financial products are suitable for all clients. 

“Lonsec believes that at the heart of the ‘expectations gap’ is an over-emphasis and over-reliance on the use of ratings in isolation from supporting research, and in isolation from fully-formed views at the financial adviser level about how a given financial product should be used and who it is and isn’t appropriate for,” Lonsec told the PJC. 

“This can lead to a ‘one rating fits all’ mentality. It is akin to a doctor (GP) prescribing an ‘approved’ drug without knowing what type of people and conditions it is designed for, what type of people and conditions it isn’t suitable for, what its dosage should be, what its side-effects are, and how the drug may react with other drugs already being taken.” 

Dixon Advisory claimed the ‘expectations overreach’ does not exist in its business. 

“Our advisers have access to external research but it is only one of the many sources of information they use when formulating recommendations,” the firm told the committee. 

“We cannot comment on how other businesses operate but it is conceivable that an ‘expectation overreach’ exists within a subsection of the financial planning industry; increased education standards for financial planners may assist in addressing this.” 

Indeed, adviser education and the Future of Financial Advice (FOFA) reforms are what might help bridge the gap. 

“Lonsec believes that the Future of Financial Advice (FOFA) reforms, specifically those relating to ‘best interests’ and ASIC’s associated guidance contained within RG175, should go a considerable way to improving this situation,” Lonsec said. 

The research house further suggested ASIC provides specific guidance to financial advisers on how to understand the financial product they’re considering recommending to their client; how to understand their client; and what the appropriate use for the product would be. 

How dangerous is the ‘pay for ratings’ model? 

According to ASIC, it is dangerous, but the conflict can be effectively managed. 

The debate around the remuneration of researchers has been long-running and reinforced by the S&P scandal in the US. 

Many industry stakeholders have long argued the conflict of interest was too large in instances where product manufacturers or funds management firms pay research houses to rate their products. 

In its submission to the Trio inquiry, ASIC finally signalled it might consider banning payments by product issuers to research houses. 

However the regulator quickly changed its view. 

ASIC asked the industry whether conflicts of interest associated with the so-called ‘pay for ratings’ remuneration model could be managed or should be avoided entirely. 

The watchdog received 27 submissions to its consultation paper, most claiming the conflict could be managed with robust processes and appropriate controls. 

When asked by the PJC why it had changed its position on banning the ‘pay for ratings’ model, ASIC pointed to the feedback it received to its consultation paper. 

“Some respondents also noted that requiring avoidance of this conflict may have an adverse impact on the availability of research in the current market,” ASIC said. 

“On consideration of the issues and submissions, our updated guidance requires providers who operate issuer-pays business models to maintain robust controls to ensure fee and contractual arrangements, relationship management and/or ancillary business units are kept separate from the ratings process and outcome.” 

While ASIC announced it would conduct ‘targeted surveillance’ of research report providers to assess compliance with its updated guidance, it would seem research houses are not subject to increased accountability in the context of client losses. 

That is – if they’re not proven to have been conflicted or careless, as the recent Federal Court ruling showed.

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